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Water: the oil of the future

Canadians tend to view the water that flows from their taps as free, and that is as it should be. But this most basic municipal service costs money, and will cost more in the future. Governments are increasingly turning to the private sector not just to build water systems but to operate them too. Report after report predicts that with resources depleting and global population continuing to grow, water could soon become as hot a commodity as oil.

In nearly every corner of the world, the supply-and-demand picture is getting out of balance. A recent report by National Bank observes that 20 years ago China had 50,000 rivers. More than 28,000 have disappeared due to climate change, industrialization and hydroelectric dams. The world’s most populous country also has just 25% of the world’s average per capita water resources. Nearly 80% of that is in the south, but two-thirds of the country’s population lives in the north.

Other emerging markets have similar needs for H2O. India pumps 190 cubic kilometres of water a year from below ground, but only 120 cubic kilometres is replenished naturally, says the report. As well, much of the water these developing nations do have isn’t fit for drinking. Only 20% of India’s sewage is treated; 58% of the water in China was found to be “bad” or “extremely bad.”

Even the U.S. is looking at a bigger water bill. The Colorado River, which services 40 million people, has suffered a 14-year drought. All of North America’s water pipes and pumps need an upgrade, which the U.S. Environmental Protection Agency says will cost US$384 billion between now and 2030. It’s estimated a quarter of treated water in the U.S. is lost due to leaks.

Higher demand for food is also putting pressure on water resources, says Angelo Katsoras, a geopolitical analyst at National Bank and co-author of the report. Nearly 70% of all treatable water is used by the agriculture industry, and that could grow as emerging middle classes eat more water-intensive foods, such as chicken and red meat.

The good news for investors is the promise held out by a growing cadre of companies working to take on that infrastructure upgrade, turning unusable water into something we can drink and making water consumption more efficient. For Steve Falci, head of strategy development at Ireland-based Kleinwort Benson Investors, the theme has so far paid off. Kleinwort’s Water Strategy fund, launched in 2001, has an 11.8% 10-year annualized return. While his company clued in to this theme years ago, he says that it’s only in the past three years that water resource scarcity has come to the fore. The investment opportunity, he says, “is driven by the need for significant solutions.”

There are three ways to take advantage of the rising demand for water: through water utility companies, industrial operations and technology businesses. Water utilities are the most straightforward. They deliver water to customers and raise prices as costs increase. Industrial companies make the pipes, pumps and valves used in water delivery systems, and they also help design and build projects. Water technology companies, which are the fastest-growing businesses, are finding ways to make the 99% of the earth’s water that we can’t drink (seawater, waste water, polluted water) safe for use.

It’s the latter two niches that present the best buys, says Dieter Küffer, a portfolio manager at RobeccoSam, a Switzerland-based investment firm. Utilities are regulated, so growth is limited, whereas industrials and tech firms can sell their wares on the open market. He expects the sector’s earnings to grow by about 13.5% a year over the next five years, with industrial and technology companies expanding at a faster rate.

While this is a global story, water demand is greatest in emerging markets and especially China, says Küffer. China needs help getting water into homes, bringing water from the south to the north and cleaning up polluted waterways. It’s estimated that the country needs to invest US$650 billion on water-related projects over the next several years. India will be a big market too, but there are economic and political challenges affecting investors there, he says. Companies with exposure to Chile, Brazil, Thailand and the Philippines are solid bets as well.

With the sector trading at about 15 times earnings, valuations aren’t cheap, says Küffer. Technology-company multiples tend to be higher still, as they’re typically faster growing, while lower-earning utilities could be cheaper. Still, with double-digit growth ahead, that’s fair value.

No matter what sector you buy into, Falci says it’s important to look across the capitalization spectrum and to diversify into different types of water businesses. Also keep in mind that emerging-market-domiciled companies often have to deal with political risks that operations in developed nations don’t. Look at valuation metrics such as price-to-earnings and price-to-book, and compare those valuations to comparable firms. For instance, water-focused industrial operations should be compared against non-water industrial companies, not utilities or technology businesses, says Falci. Also look at management, cash flow generation and yields. A number of companies pay attractive dividends.

One drawback for investors is that the largest companies in this arena have numerous non-water divisions. That makes it more difficult to find a pure-play water investment, says John Gabriel, an exchange-traded fund (ETF) strategist at Morningstar. For those who don’t want to do all the due diligence required to invest in the space, there is a handful of water-focused exchange-traded funds to buy. Look for the ETF with the least amount of utility-sector exposure, says Gabriel, and also be aware that many of the companies in these funds are small- and mid-cap names.

Investors will have to patient. Governments are seldom quick to make capital investments, so it could take a while to see major gains. But those gains will come. “Water is the new commodity,” says Gabriel. “It’s the oil of the future.”

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